This article appeared in the March 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By John Abernethy, Clime Asset Management
Investors, overall, were probably too optimistic heading into the recently concluded first-half reporting season, with earnings expected to grow around 10 per cent for the market. Earnings growth, however, is likely to be around 5 per cent.
The market underestimated the ongoing effects of the high Australian dollar and the downturn in resources capital spending, both of which are filtering through the economy.
The Australian economy is slowing, but there are pockets of strength for investors, mostly related to the recovering housing market, which is benefiting banks and builders. The challenge for investors is that they are paying a premium, for banks particularly.
Business is facing one of the most volatile environments since the industrial revolution. During this earnings season we have seen that some companies are managing the environment well; others are being severely disrupted by massive changes in the world economy, particularly the internet and emergence of China.
Overall, there are five key things Clime has learnt from the reporting season:
1. BHP Billiton is listening to shareholders
BHP Billiton and Rio Tinto had promised the market they were striving to boost productivity and cut back on exploration costs as they adapt to an environment of lower commodity prices. Following a change of management at both companies, the market wanted to see action before it believed them.
The miners' recent earnings reports show they are delivering on their promises, with strong cost-cutting and sharp declines in exploration and capital spending. That helped boost BHP's first-half profit 83 per cent to $US8.1 billion; Rio's underlying full-year profit was up 10 per cent to $US10.2 billion.
We also received strong indications this discipline will be maintained. We perceive that both Rio and BHP will seek to generate better cashflows in an economic environment where China is demanding more bulk commodities.
2. China's demand for bulk commodities continues
Last year, many mining analysts and macro-economists were sceptical about the strength of China's growth cycle. But during this reporting season we have learnt that China's demand for bulk commodities is still there and growing.
Many analysts, basically, got it wrong, which had hurt share prices of mining and mining-related stocks. They were forecasting an iron ore price of $US80 per tonne; it is now $US120 and holding. The strength in demand has also been reflected in China's trade accounts released in January, in which exports from Australia - dominated by bulk commodities - were substantially higher.
3. Banks in housing lending sweet spot
The Australian economy is slowing and so is credit growth. Banks are struggling to grow assets in the business and personal finance space. But this earnings season, particularly with the release of Commonwealth Bank's 16 per cent surge in first-half profit to $4.2 billion, and ANZ's 13 per cent earnings growth in the December quarter, show that banks are benefiting from strong housing lending.
The housing market is being buoyed by population growth and foreign buyers. But investment buyers, attracted by market price movements that stimulate investment activity, are also being quite aggressive. There is also a lot of activity from the likes of baby-boomers downsizing.
Banks are in a sweet spot. They have got excellent economies of scale in the mortgage lending part of their business; they sell a loan and it's on their books for 20 years. They can also fund housing asset growth without diverting significant capital to it because of risk-weighting rules.
4. The building sector is strong
The strength of the housing market is also benefiting another sector: building. Boral delivered a 73 per cent surge in underlying net profit to $90 million, helped by cost cutting but also a turnaround in the Australian building products division.
Despite the slowing economy, the housing pick-up cycle is likely to last and continue to benefit building companies. Outlooks for builders will be pretty good in that environment. They will also benefit from an improvement in operating costs if the carbon tax is removed from July 1 as expected.
5. Retail will struggle in the second half
Sales figures from retailers in the first half, such as Woolworths and JB HiFi, were reasonable despite a difficult climate - particularly with unemployment picking up. There was also a solid Christmas recovery spurred by the historic low interest rates.
But it was clear that retailers snuck through the first half, and that discretionary retail will be tested in the second half. Unemployment is likely to increase; the honeymoon period for the Abbott Government, if there was one, is clearly over; and a difficult Federal Budget is looming. All in all, consumer sentiment is on the wane, which means a tough time for retailers coming up.
The results from five stocks have particularly impressed us:
1. Telstra Corporation
Telstra is now managing to grow profits. The telco generated a 9.7 per cent increase in first-half net profit to $1.7 billion and raised its dividend to 14.5 cents from 14 cents. This is the first dividend increase in eight years.
The good news is that its mobile business continues to perform better and add more to Telstra's bottom line than its fixed-line is detracting. Mobile revenue in the half was up 6.4 per cent to $4.86 billion; fixed-line revenue fell 1.5 per cent to $3.62 billion. That trend looks sustainable. Telstra is also managing costs well and offloading peripheral assets.
2. Commonwealth Bank
As mentioned, a focus on the residential housing market is paying off for the banks in general and the Commonwealth in particular. CBA's home loans in the first half rose 7 per cent, giving it a market share of 25.3 per cent. The bank also saw a drop in bad debt charges. In the context of a difficult economic environment, it was a good result, although investors are currently paying an expensive price for the stock.
3. BHP Billiton
We have already noted that BHP and Rio are delivering on shareholder expectations. BHP's result was a highlight with underlying profit, which excludes one-off items, rising 31 per cent to $US7.8 billion. Cost management was also a feature. BHP's capital and exploration spending, for example, will fall by a quarter this year to $16 billion, and fall again the year after. There were also volume increases across its product lines, such as iron ore. The company grew its dividend by 3.5 per cent, although that is hardly sufficient given the substantial improvement in cashflows.
4. REA Group
REA Group, which operates websites such as realestate.com.au, continues to have excellent performance. First-half profit was up 37 per cent to $70.69 million, while sales jumped 30 per cent. It, too, benefited from the strong housing market and is performing much better than its competitors. However, its offshore results showed little evidence that its local success will be replicated internationally.
5. Monadelphous Group
Monadelphous was a stand-out performer in a weak mining-services sector. In the first half it increased revenue by 10 per cent to a record $87.1 million. Cost savings offset a 1 per cent fall in revenue. It was a good performance, and the company probably has the best-managed order book in the mining services sector. However, its outlook is challenging and the company expects full-year sales to drop 10 per cent.
About the author
John Abernethy is the Chief Investment Officer of Clime Asset Management. The Clime Australian Value Fund is one of the best-performing Australian equity funds.
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